Single Factor Stochastic Models with Seasonality Applied to Underlying Weather Derivatives Variables

The authors employ single‐factor models to estimate daily temperature variations for the valuation of weather derivatives. Classical financial models are adapted to fit temperature seasonality to a time series. As an example, Monte Carlo simulations of heating and cooling degree‐days are used as the underlying for weather derivatives that reference temperatures in regions of Spain. The article also discusses potential applications to hedging energy‐related risks.